Article Number 3 in the Mutual fund series (For the previous article click here)

In the previous article I had briefly pointed out some of the benefits that mutual funds have to offer. As a brief recap we had seen that mutual funds are beneficial because they are basically managed by professionals, some of them are well diversified and hence less risky, comparatively they cost lower and are convenient. Unlike hedge funds, they are quite transparent and well regulated. There is no shortage in the variety of mutual funds and suit pretty much any investors need. We had also seen that equity oriented funds are quite liquid and provide greater returns but at a greater risk. Finally we had seen the SIP as a wonderful way of investing for those who don’t or can’t invest at one go (lump-sum).

In this article lets see some of the disadvantages of mutual funds.

1) Losses are uninsured, Market risks are real

We had seen in the previous article that mutual funds are well regulated (by the SEC in USA and SEBI in India). However one must remember that they are not insured. Investing in stocks via mutual funds doesn’t provide you with any insurance against losses. If the funds NAV decreases, you lose money for real and there is no compensation or insurance.

However, we must realise its in the very nature of the markets to be uncertain and unpredictable (to an extent). Since we expect higher returns while investing in mutual funds (than say risk free treasury bonds) we must similarly expect a higher risk as well. Risk and reward are usually considered two sides of the same coin.

2) Over diversification? “Diworsification”

Diversification to an extent is good in that it reduces the overall risk of the portfolio but what happens when we do too much of it? It ends up substantially reducing the returns thereby defeating the purpose of investing in mutual funds. More »